High risers (Archived)
With valuations for US commercial real estate at all-time highs, a focus on first-lien debt and bridge loans could make sense for investors in search of attractive opportunities in 2018, says Sandeep Bordia, head of research and analytics, Amherst Capital Management.
A return to form has been the name of the game in recent years in US commercial real estate (CRE). In aggregate, the sector has recovered from the depths of the great recession which began in 2008 and asset prices overall are now at all-time highs.1 Moody’s/RCA CPPI overall price index, for example, is now 19% higher than 2007’s peak before the most recent recession. Versus the crisis bottom, CRE prices on average are 84% higher. CRE’s return to form over the past few years begs an obvious question: Is the segment overvalued – and, if so, how should investors react?
On the question of valuation, Sandeep Bordia, head of research and analytics, highlights how the post-recession recovery has been driven by a combination of rising rental income and compression in capitalisation rates (a measure of a property’s income relative to its price). A big chunk of the price growth has come in from cap rate compression, he adds. In addition, prices in CRE have risen faster than single family housing, which are up 10% above their pre-crisis peak, according to the Amherst Home Price Index (HPI).
Even so, and despite the question of rising valuations, the trend in CRE prices needs to be taken in a wider context, says Bordia. He explains: “CRE is no different from other income-producing asset classes such as equity consumer staples, where yields have fallen below pre-crisis levels, driven by low real interest rates in the US market. In our view, the CRE market is not necessarily cheap on an overall basis, but is in line with most other asset classes.”
One area where investors may be able to ‘pick their spots’ in the current CRE market is first-lien debt. Here, says Bordia, investors have the potential for better risk-adjusted returns than from pure equity positions in CRE.
Transitional – or bridge loans – Bordia explains, are backed by properties that are underperforming and in need of capital and a business plan execution to bring them to par with the rest of the market. These loans typically have three- to five-year terms with floating-rate coupons and also tend to have much higher rates than loans on stabilised properties. “Data suggests there is strong mean reversion in the performance of CRE properties and the higher rates on bridge loans more than compensates for the additional risk versus loans on stabilised properties.
More broadly, Bordia points out that not all CRE has done equally well. The recovery has been stronger in some parts of the market than others, with geography playing a strong role in driving disparity in price rises. “In general,” he says, “major markets such as New York, San Francisco, Los Angeles, Boston, Chicago and Washington DC have witnessed a much sharper increase in prices than secondary markets.”
The disparity also holds true across sectors. Notably, the largest price growth has been in the apartment and central business district (CBD) office building sectors, where valuations are over 52% and 30% higher, respectively, than the previous peak value in 2007 according to Moody’s/RCA CPPI. Similarly, industrial properties also witnessed rising values in recent years, aided by growing demand for distribution centres to power the e-commerce economy. The contrast here is with retail (particularly low- and mid-tier malls) and suburban office sectors, which have lagged the wider recovery and remain below their 2007 peak prices. These sectors, concludes Bordia, have fallen behind largely because of structural trends such as the desire to work in cities and the declining popularity of brick-and-mortar retail relative to e-commerce.
1. Real Capital Analytics, Commercial Property Price Indices as of October 2017This is not investment advice. Regulatory Disclosure